Momentum Continues Despite Pessimism

The week’s economic data was positive on balance. Given that the economy is largely consumer-driven investors are keenly interested in the health and intentions of the US consumer. The data on his health is largely positive. Wal-Mart and Costco were upbeat in their projections for the next quarter earlier this week. Today, the Commerce Department reported that retail sales increased 0.6% in September, more than forecast, following a 0.3% gain the prior month.

But on a sour note the University of Michigan preliminary index on consumer sentiment fell to 82.0 from 83.4 in September. It averaged 89.6 during the first part of 2007. The data show that the consumer is being impacted by the steady drone of negative media on the economy caused by the declines in housing. However, as we have seen in years past, it is what the consumer does that is important, not what he tells pollsters. 

If the consumer is taking a rest, the business side of the economy is firing on all cylinders fueled by a strong global expansion. The weak dollar is having a positive impact on the sales of US products and services abroad. The US deficit in international trade of goods and services shrank by 2.4% in September. During the month, US exports grew 0.4% to $138.34 billion, led by sales of industrial supplies like gold, cotton and chemicals. Meanwhile, imports fell 0.4% to $195.92 billion, despite high oil prices. 

The downside of a weak dollar is that it takes more of them here at home to buy imported goods like Hondas and Lexuses (or is it Lexi?).  A Labor Department report today showed that headline import prices matched Wall Street’s expectations in September by rising 1%, after falling 0.3% in August. The report also detailed the fifth-straight rise in prices of goods fromChina, suggesting the US can no longer count on cheap imports from that country to offset domestic inflationary pressures according to the Wall Street Journal. But beyond the volatile food and oil sectors, prices are largely contained. Joel Naroff of Naroff Economic Advisors said today in the WSJ “for those who worry that the falling dollar will cause import prices to surge, think again, it’s just not happening.” 

So far, the pessimistic media regarding the economy’s weakness and its chances for recession has also been overstated. A recent survey of economists polled in the latest forecasting survey conducted Oct. 5 through Oct. 9, showed the average forecast for the chance of recession moved lower to 34%. That was the first decrease since June and followed a forecast of a 36% probability of recession in the September survey. 

A recent Barron’s article highlighted work done by Credit Suisse economist Jay Feldman and econometrician Henry Mo. The pair devised a trio of recession models that come remarkably close to being free of false signals. With rare exceptions, whenever they signaled that a recession had at least a 50% chance of occurring, a recession did take place, although not always within the precise time-frame that the model suggested. And with no exceptions, whenever the models signaled that a recession had less than a 20% chance of occurring, a recession didn’t materialize, at least not within 12 months of when the reading was given. How do the readings look now? In all three cases, they show that a recession has less than a 20% chance of occurring. 

Experts are mixed on whether the Fed is finished reducing rates given their need to balance inflation risks against the risks of a slowing economy. But, what we know about Ben Bernanke is that he has demonstrated a bold willingness to act decisively to stimulate the economy, ahead of significant conclusive evidence of economic slowing. We believe he will not fail to act again if he and his governors believe the economy is in danger of rolling over. 

Credit Suisse’s forecast for 2008 real GDP growth is 2.6% on a Q4 over Q4 basis. They expect a stronger second half than first half, as the residential investment drag begins to diminish (although not vanish entirely), and if the rest of the economy holds up. They point out that as housing’s contribution to the economy diminishes, its ability to slow the economy diminishes. When residential investment was more than 6% of GDP, it was a potentially weightier drag than in the current circumstance when it is less than 5% of GDP. They expect it to fall below 4% of GDP before this cycle is over. 

They also point out that evidence of the last 18 months has shown that that housing is not nearly as central to consumer spending as is often asserted; jobs and wages matter much more. Nonetheless, a less liquid housing market should imply at least some rise in the personal savings rate and some modest slowing in consumer activities.

So far, in the early stages of the third quarter earnings cycle 49 or 8.4% of the companies in the S&P 500 have reported their earnings. A full 69% are better than those expected by analysts and 26% are lower. As of October 4th, 384 companies in the Dow Jones Wilshire 5000 have reported an average gain of net income by 9%, considerably better than analysts expected.

We will lighten or remove our more optimistic positions from our growth portfolios should it become apparent that the US economy will slow faster or deeper than is currently expected. But at present it appears that the global expansion is still firmly intact and that the US economy will weather the housing collapse and regain much or all of its former strength. But the compelling growth remains overseas in both developed and emerging economies.